Bear Stearns and Gentle Ben
Ride me down easy, Lord
Ride me on down
Leave word in the dust where I lay
Billy Joe Shaver
People ask me, "How is he doing?" How is Ben Bernanke doing as Fed Chairman? Is he making it up as he goes, making monetary policy by the seat of his pants?
My answers are that he is doing quite well, thank you, after a slow start in the summer. But, from that first cut in the discount rate through yesterday (Sunday), he has been right on, innovating (seat of the pants innovation) to make up for the fact that the traditional tools of monetary policy aren't well suited for the current crisis in financial markets.
This crisis is unique — literally. It's a crisis of fear that you won't be repaid for loans you make and fear that your counterparties in large transactions may go belly up, or otherwise stiff you. There is a massive shift from the absence of meaningful risk premiums to overly large premiums not only on risk but on instruments that hardly seem risky (like Fannie and Freddie-backed securities, for example).
Chairman Bernanke's creation of auctions for money to take away the perceived stigma of using the discount window was right on, as was the decision to liberalize borrowing and collateral terms and requirements. The quick intervention over this past week-end to assure an orderly resolution of Bear Stearns was handled with excellence.
One issue I've heard no-one mention during this slow-moving train wreck is what the proper relationship between the Fed funds rate and the discount rate is. During my tenure on the FOMC, the discount rate was at a discount much of the time, which was contrary to conventional wisdom dating back to Walter Bagehot's Lombard Street, which could have been titled as a guide to central banking in times of crisis.
Chairman Greenspan and the Committee looked forward to opportunities to restore the premium to the discount rate. At the conclusion of that long process the discount rate was essentially pegged one percentage point above the target Fed funds rate. After about three years of this passive status, the discount rate was largely forgotten by financial talking heads.
The Bernanke Fed was correct to focus first on the discount window and dropping the discount rate by 50 basis points. Subsequent target reductions in Federal funds included equal reductions in the discount rate, thereby keeping the differential constant at 50 basis points. Sunday's move, in cutting the discount rate another 25 basis points puts the premium at only one quarter of one percent.
I assume that the choice of 25 basis points on Sunday was designed to dovetail with what Chairman Bernanke had in the back of his mind to recommend to the FOMC on Tuesday. My experience tells me there was no open discussion of what Tuesday's decision should or would be, but the tone of the discussion probably gave all the members a clue as to what the Chairman is likely to recommend.
Not long ago, I thought the FOMC should either do nothing tomorrow or next to nothing. That is no longer possible, and I now expect another large move.